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The Gaming Industry: Back to the Future

November 12, 2004

Location

National Tax Association Annual Conference

Presented by

Frank J. Fahrenkopf, Jr. President and CEO, American Gaming Association

It’s a pleasure to be with you today to discuss a subject that has become critical to our industry’s future, and that, of course, is taxes. Before I do that, I’d like to give you a brief overview of our industry and the role of my organization, the American Gaming Association.

The AGA is the national trade association for the commercial casino segment of the gaming industry, which consists primarily of publicly held casino companies listed on the New York and NASDAQ stock exchanges. We represent most of the companies you’re probably familiar with, including Caesars, Harrah’s, MGM MIRAGE and many others, although with all the mergers taking place the total number of companies is shrinking fast!

The AGA’s mission is to represent our industry on federal legislative and regulatory issues, including tax matters. To guide our actions in an area that is both complex and critical to our business, years ago we established a Tax and Finance Task Force, which consists of the top tax experts from our member companies, and I expect some of them are here at this conference.

While the popular media tends to lump us together, the gaming industry is actually comprised of many different segments. The segment I represent, commercial casinos, only do business in 11 states. But there are also state-run lotteries in 40 states plus the District of Columbia; some form of pari-mutuel betting in 43 states; Native American casinos in 28 states; racinos in seven — but soon to be nine — states; and charitable gaming in 47 states and the District of Columbia. The entire industry employs, directly and indirectly, more than 1 million people, and in 2003 had total gross revenue of more than $72 billion. Of that amount, just over $27 billion can be attributed to the commercial casino industry, which has a work force of about 350,000 people.

We grew to where we are today in large part because of the wave of casino growth that occurred in this country over the past decade. This growth brought great things for the industry, but it also revolutionized the way casinos are taxed. What I’d like to do today, as the title of my speech implies, is to take you back to the future. In other words, take you back to the early 1990s so you can see how we got to 70 percent-plus tax rates and then look ahead to 2005 and beyond so we can promote a better understanding of our industry and the importance of sound fiscal policies.

As some of you are no doubt aware, the industry got a wake-up call in 2002 when the state of Illinois unexpectedly increased the tax on gross gaming revenue from 35 percent — already the highest of the 11 commercial casino states — to 50 percent. Unfortunately, the entire industry hit the snooze button, because just when you thought the tax rate couldn’t go any higher, the governor of Illinois pressed legislators to raise it again last year, to an astounding 70 percent of gross gaming revenue.

The truth is — and I think Marc will attest to this as well — nobody really thought it would happen. When it was first proposed, the almost universal reaction was disbelief. One analyst called it “outrageous” and “stunning.” Another called the volatile business climate in Illinois “inhospitable.” Others thought it was “suffocating” and even “punitive.” And yet, legislators still approved it without much of a fight. That says something very significant about how our industry is viewed in Illinois and other states where tax rates have climbed to levels that make it difficult, if not impossible, for our companies to get a fair return on investment.

Although some people would consider the decision to impose a 70 percent tax rate on Illinois casinos our wake-up call, the genesis of this actually can be traced to a much earlier date. Back in the early 1990s, the U.S. economy was struggling, particularly in the upper Midwest and the South. States in these regions could have cut government services — denying them to people at a time when those services are needed most — or increase taxes across the board on businesses — which would have inhibited capital investment and economic expansion. Instead, they went for a third option: They turned to riverboat gaming as a new source of revenue. It was an easy choice for a number of reasons. 1) It is environmentally clean; 2) It is capital intensive; 3) It produces jobs and economic expansion; and 4) Because it is a privilege and not a right to have a gambling license, the industry can be taxed at rates higher than most other businesses.

In nearly every state that adopted riverboat gaming in the 1990s, the demand for a steady stream of tax revenue far outweighed, or even overwhelmed, the desire to promote overall business growth. The object was to extract as much revenue as prudent from gaming operators, up to that limit where it became a barrier to market entry. Simply put, government wanted more of the profit in exchange for the right to operate a casino.

Of course, the industry can and will pay more under certain conditions. In states where there is a high profit potential based on the size of the market, the amount of competition and other factors, operators can be taxed at a higher rate.

But there are limits to what any business can do and still earn a fair return on investment for its shareholders, and there are long-term implications for the state that, frankly, are being ignored. Plans intended to stimulate the economy have instead had the opposite effect of actually suppressing capital investment and other expenditures, jeopardizing jobs, and, in the end, reducing rather than increasing tax revenue.

Elected officials need only look at Illinois to see the long-term implications of unreasonably high tax rates. Analysts who follow this industry, such as my friend Marc, have emphasized that these high tax rates deflate return on investment, making our companies’ shareholders less likely to support either new or improved operations. After the first tax increase in Illinois, Deutsche Bank found that the 2002 gross gaming tax increase resulted in lost jobs, lower overall revenues and a significant decline in potential capital investment in the state. In the six-month period following the tax increase, gaming revenues in Illinois declined 2.1 percent, to $1.02 billion. This was the first sustained period of decline in the history of the Illinois market and came despite the addition of significant capital investments.

The second tax increase brought more of the same, threatening the industry and state fiscal security in the process. A plan that was originally intended to stimulate a sagging economy had the exact opposite effect, lowering gaming revenues by 10 percent compared to the previous year, cutting the number of casino jobs by 5 percent and bringing in less than half of what it was expected to produce in tax revenue for the state. At the same time, it sparked revenue increases of 11 percent across the river at casinos in St. Louis, Missouri, where lower entry fees attracted former Illinois casino customers, and in neighboring Indiana, where they also saw a jump in revenue.

This outcome should not have been unexpected. In its 2002 annual report the Missouri Gaming Commission cautioned against tax increases, saying they would discourage investment, and a 1998 report by the Council of State Governments urged state officials to consider lower tax rates to encourage investment.

Even the business community has weighed in on this debate — with similar results. In 2003, Illinois legislators rejected a plan supported by the Illinois Chamber of Commerce, which would have increased the number of gaming positions, resulting in $365 million more in state and local taxes than was earned in 2001. The analysis also found that the plan would inject an additional $2.2 billion into the Illinois economy and create close to 50,000 new jobs. Instead of adopting this plan, lawmakers opted to increase the tax rate from 50 percent to 70 percent, with the negative cash result I discussed earlier.

As I said before, the emphasis on the tax stream began with the riverboat states, which, with the exception of Mississippi, viewed the industry primarily as a source of revenue. These states set gross gaming tax rates at more than double the rates in Nevada, New Jersey and Mississippi, where the focus was more on creating jobs, promoting economic development and tourism, stimulating capital investment, and improving the overall economy. While nearly every state is under pressure to generate new revenue in order to address budget deficits, states that established casinos primarily to serve as revenue generators have been more likely to turn to the industry during tough economic times. With governors and legislators reluctant to raise income, sales or property taxes, gaming tax increases have become politically expedient. It reminds me of something Sen. Russell Long once said: “Don’t tax me, don’t tax thee, tax the man behind the tree.” Of course, the casino industry is always the man behind that tree.

Today, in any new or prospective jurisdiction, the tax stream has become paramount, overshadowing all other priorities. States with slots at racetracks, or racinos, have established effective tax rates as high as 80 percent in New York. Half of these racino states have tax rates above 50 percent, and the other half have tax rates ranging from 20 percent to 45 percent. You rarely hear calls anymore for quality jobs or economic development — just a call for tax revenue.

That has led some in our industry to declare that they will now limit their investment to states with a stable, predictable tax environment. Terry Lanni, the chairman and CEO of MGM MIRAGE, one of the largest casino companies in the world, joked that maybe his company should move to Mississippi after Gov. Haley Barbour announced that he was “against raising anybody’s taxes, period.” More recently, MGM MIRAGE has said that it would focus all of its domestic investment and development plans on Nevada, New Jersey and Mississippi, where they have “reasonable taxes and understand our industry” as opposed to other jurisdictions, where the company did not foresee any big growth or investment opportunities.

That strategy has played out, as two mega-mergers announced this year would significantly increase the Las Vegas presence of industry leaders MGM MIRAGE and Harrah’s, leaving them less vulnerable to the whims of lawmakers in some of the newer jurisdictions. Just this week, MGM MIRAGE also unveiled plans to develop a multibillion-dollar “urban metropolis” on the Las Vegas Strip. The 18 million-square-foot first phase of the project calls for a 4,000-room hotel and casino, three 400-room boutique hotels, 1,650 luxury condominium-hotel units and 550,000 square feet of retail, dining and entertainment space.

Despite the obvious benefits for Nevada, New Jersey and Mississippi, the decreasing number of investment opportunities is not a positive trend for the industry overall — or for the states. The question is, can we go back to the future? Can we learn from this experience and avoid repeating it?

One thing we can do to avoid repeating past mistakes is to promote a better understanding of just how our industry works. Although so much of what we do is subject to public scrutiny, there’s still widespread misunderstanding and distrust of our business. To address this problem, the AGA now participates if we are invited to state or even foreign government public forums. Since we began doing this in 2003, I have testified at hearings in Maryland, Massachusetts, Pennsylvania, Rhode Island, and just this year before the British Parliament in the U.K.

On a related matter, we need to do a better job of providing a basic education on the fundamental economics of our business. I like to tell the story about a call we received from a member of the editorial page staff of The Washington Post asking why Maryland track owners wouldn’t think $6 billion in revenue over 20 years was enough. There was little or no understanding that revenue does not equal profit, particularly in a high-tax environment. There also was no consideration given to return on investment, an expectation for any publicly traded company. It is in these areas where I hope we can work closely with your organization. Nobody has a greater understanding of taxes and their impact than the members of your association, and I appreciate the fact that you are providing a forum for us to discuss this important issue.

I think Winston Churchill had it right when he called taxes “a grave discouragement to enterprise and thrift.” If the economic benefits of gaming are to be realized across the nation, our industry needs to continue educating, overcoming myths and stereotypes, and emphasizing the long-term implications of ill-conceived tax policy. I hope that by examining what has occurred in the past and anticipating future developments, we can better inform policy-makers about the potential long-term impacts of their tax decisions.